Reeling in Consistent Gains

July 29, 2001

By James A. Anderson Weekend fly fisher David Wallack says you shouldn't force things out in the stream. When your line gets tangled and your temper grows short, you breathe deeply, take in the scenery, and resume fishing after your emotions have settled.

Standing waist-deep in icy water sounds like the perfect hobby for a portfolio manager with a value investor's approach. Wallack, who runs $365 million in assets for T. Rowe Price's Mid-Cap Value fund (TRMCX), says the patience required to bag five or six trout in one trip is put to good use in his day job.

NETTING PROFITS. Wallack took over what was already a successful operation on Jan. 1 and has kept to the same formulas that made his predecessor, Greg McCrickard, a success. That's not surprising, considering that Wallack had worked on the fund's investment committee as an analyst since its inception in 1996. He has maintained McCrickard's calm, measured approach, as well. A case in point is the fund's rather conservative 25% turnover.

Good stock picking, though, affords you the opportunity to stand your ground. As of the market's close on July 26, the fund was up 7.0% year-to-date, vs. a poor showing of -6.7% for the Standard & Poor's 500. Over the last three years, the fund has averaged a yearly total return of 10.2%, beating the 500 by 7.3% points, and its 5-year average annualized total return of 15.9% edges the benchmark by 0.7%.

"This is just a solid fund, one that is pretty evenly weighted across economic sectors," says Morningstar analyst Catherine Hickey. "It's a steady above-average performer, one that isn't so volatile that you'll find it in the top performers or bottom performers any quarter, but it's one that has delivered very good returns over time."

BASIC Still, for a value manager, Wallack casts his net across a wide variety of industries. Of course, he has stocked up on value-investing staples -- financial companies and a variety of cyclicals. A group in Wallack's good books is basic materials -- a classification that spans paper, steel, and mining firms, such as current holdings Newmont Mining (NEM), Inco (N), or Potlatch (PCH).

Wallack has moved 23.4% of his fund's assets into the sector and other industrial cyclicals, vs. 17.7% for the average mid-cap value fund, according to Morningstar stats. "For much of the past decade, commodity prices have been low," Wallack explains. "That has kept global capacity down and triggered a lot of consolidation within these industries.

Do a double-take, though, and you'll spot a few things that don't often crop up in your basic, buy-it-cheap-and-wait-a-while fund. One example is Mid-Cap Value's 12% stake in tech shares, according to Wallack, vs. 9.4% for its peer group, according to Morningstar. Wallack says there are two good reasons for the fund's position: "That's just where the value is, from PC manufacturers to telecom equipment makers to semiconductor companies," he asserts. Now that Wallack has taken a stake, don't expect him to parachute anytime soon: Mid-Cap Value aims to hold stocks from 2 to 5 years. That gives the manager ample leeway to swoop into battered groups, take a position at cheap prices, and then wait for a change in fortune, he says.

WARY OF UTILITY. Meanwhile, Wallack is down on electric utilities, an industry that has been a value-investing stronghold. "It's our feeling that the industry is going to be an increasingly treacherous place to invest," he says. "Managers in the industry have spent years focused on negotiating with regulators, and we doubt they have the skill set to deal with the kind of price volatility we expect in the sector." It's little wonder, then, that utility shares make up just 4% of the fund's holdings.

Wallack starts his stock searches by focusing on companies with a market cap of $300 million to $12 billion. On his first pass, he combs the market looking for stocks that have at least 50% in the last 6 months to 12 months. "When they fall that much, it's time to start looking them over," says Wallack. He discards about 90% of the remaining group via number-crunching and putting them through a battery of value-investing criteria.

There is no single, formal set of screens to choose stocks -- Wallack employs industry-specific measures. If he's looking over a media firm, he'll examine price to cash flow. For technology stocks with battered earnings, he'll turn to price to sales as a yardstick. For mining and paper operations, he'll calculate the amount it would take to replace assets and product and then weigh a company's share price against that figure.

As a rule, Wallack says he prefers relatively debt-free picks. Typically, he'll angle for companies with obligations to creditors totaling no more than 30% of their capitalization, although he's willing to stretch that figure to as high as 50% for some groups which tend to be more leveraged, such as media companies.

STEEL PLAY. The result of all the handiwork is a portfolio that is thrifty by most measures. As of May 31, 2001, Morningstar reports that Wallack's portfolio carried a 3.2 average price-to-book ratio, just less than half that of the S&P 500. Its average price-to-earnings ratio of 22.4 was 24% below that of the benchmark.

Wallack inherited a sizable stake in steelmaker Nucor (NUE), and he has been building on that of late. "They've grown the book value of the company by 50% the last five years, doubled the dividend payout, and increased production over 40%," he gushes. How can it still be a value play? The company is hard at work on a new technology, called thin strip casting, that could well revolutionize the steel industry. Wallack thinks that once the market appreciates the new development and its ability to jolt Nucor earnings, the stock will be well on its way to $100 from its July 26 close of $47.82. Mid-cap Value started buying Nucor in 1997 and paid an average price of $45.63 for the company.

What the market has done for oil drilling contractor Diamond Offshore (DO) has disappointed Wallack so far. Mid-Cap Value has spent an average of $35 a share for the company, yet has seen Diamond's shares drop to $30.84 a share at the close of trading on July 26. Wallack's still a fan, even though he thinks recent softening of the price will hurt the shares over the short-term.

SLOW AND STEADY. He says management understands the drilling business better than any other in the industry. "They aren't in the business to be big boys with big toys, as some managements are," says Wallack. "They know when to buy rigs and when to sell. They now how to create value over time." Better yet, says Wallack, the company is selling at a market discount of at least 20% to the value of the oil rigs in its fleet. Wallack says the company should reach its replacement value of $60 in the next 18 months to two years.

As good as things have been, don't expect Wallack to hang a "gone fishing" sign on the door knob to his office anytime soon. "Last year, when technology names were still riding high, we found a huge number of good franchise companies at very low valuations," he says. "This year, we still run across quite a few ideas, but if I add one new name to the fund a week, we feel we're doing a lot." Sounds like T. Rowe Price Mid-Cap Value has found a full creek and the right bait to keep reeling in the catch of the day. Anderson teaches journalism at the City University of New York. Follow his twice-monthly Mutual Fund Maven column, only on BW Online